Time to bite restructuring bullet
Governments in Europe knew they were taking a massive step when, forced by circumstance, they agreed to various bank bailouts to stabilise the financial system in the wake of the 2008 global financial crisis.
These measures, of course, proved just a stopgap solution. In sum, accumulated debt and systemic risk were not reduced. They were simply redistributed, transferred from one balance sheet to another, with the effects of those decisions played out in Europe's sovereign debt crises, and the belated attempts to re-establish fiscal control.
These events, which now have such a bearing on the future working of the world economy, were the subject of the latest Hong Kong University of Science and Technology (HKUST) and New York University Stern School of Business (NYU Stern) Global Finance Seminar which addressed the causes, consequences and possible remedies to the debt crisis. The event, held in early December last year, was co-presented by the South China Morning Post, Bloomberg and JPMorgan.
Assessing how to stop Europe 'drowning in debt', keynote speaker Viral Acharya, professor of finance at NYU Stern, outlined - with particular reference to Ireland - how bailouts for the financial sector had 'ignited' sovereign credit risk in supposedly developed European economies.
The result for governments prepared to step into the breach was perhaps foreseeable. By providing funds or guaranteeing deposits for distressed private sector banks, they faced up to the inevitable, but they were, in a sense, entrapped.
The primary goal, from the standpoint of stabilising the financial sector, may have been met. Be this as it may, the question which still has no definitive answer is: at what cost to individual nations, the euro zone, and other international institutions?
'It is a somewhat simplistic explanation, but the usual view of government bailouts is that someone is sitting out there with a pot of money,' Acharya said.
'But it is not infinite. It is backed by future tax collection and the debt markets. Governments are constrained too, so bailing out banks at any cost [amounts to] a transfer of risk from bank balance sheets to sovereign balance sheets, something which has boomeranged and come back to hit them,' Acharya added.
The Irish example, replayed with local variations in other European countries, showed the knock-on effects of 'backstopping' badly exposed banks. Austerity measures, tax hikes and the likelihood of capital flight all weighed down the chances of economic growth and early payback of assumed debt.
Countries, Acharya noted, do have an option to default. Iceland, for example, did not bail out its heavily indebted banks. It put a moratorium on bond payments and a stay on payments to creditors. But as more recent events have shown, economies operating within the euro zone system don't necessarily have such freedom to go it alone.
Offering one solution - by no means perfect - to pull indebted nations and banks out of the current 'terrible mess', Acharya highlighted the need for an orderly restructuring that did not try to find new answers to each evolving crisis. The latter approach simply panders to narrower interests and short-term intangibles such as market sentiment, Acharya added.
The focus should be on re-establishing a well-capitalised banking sector, capable of taking a 'hit'. Solvent banks will be able to fulfil the prime function of providing credit to households and businesses. Inevitably, this would require stringencies and perhaps unfamiliar disciplines, but Acharya recommended it as a 'no regret' approach.
To manage euro zone or global systemic risk, an essential element is for large institutions - the 'too big to fail' banks and others - to hold enough cash to guard against possible shocks.
Models to calculate how much extra capital each would need to weather a storm are readily available. Indeed, the NYU Stern School of Business has a website ranking banks by systemic risk measures such as marginal expected shortfall. This shows, for instance, the forecast impact on capitalisation if the global equity market fell by 2 per cent.
In addition, as part of any restructuring process, it must be made clear to financial institutions that, as commercial organisations, they bear full responsibility for their own actions and liabilities.
'You have to stop socialising losses,' Acharya said. 'If banks and bank insiders have something to lose, they will think twice about taking these bets. No [restructuring] is painless, but the only way to resolve the crisis is through a write-down of debt. If firms make the losses, they should take the costs.'
As for fiscal union in Europe, Acharya believes this was not an answer to the current problems.
'If banks think their debt can be swapped with the ECB [European Central Bank], they can still get into trouble. The ECB has to stop recognising that bonds of different countries can be swapped in unlimited quantities,' he said.
Noting that the economies of highly leveraged countries could only recover through growth, Acharya foresees turbulence this year. Financial sector woes and the sovereign debt crisis have not gone away, no matter what budget constraints and new lending mechanisms may now be in place.
'If things don't improve quickly, we may see more bank failures. Governments could again take equity stakes, telling creditors we are guaranteeing your bad assets - but this exposes taxpayers to potentially massive losses. If banks and unsecured bondholders don't take a loss, it is inconsistent with market expectations and a national moral hazard,' Acharya said.